Why You Should Use ETFs Over Unit Trusts
The financial advisory industry in Singapore and probably many other countries is still very much skewed towards the use of actively managed unit trusts (aka mutual funds) to construct portfolios for their clients. And one key driver is monetary incentives. If you purchase a unit trust through financial advisers or banks, it is common for them to levy an upfront sales or subscription charge which can go up to 5%. Alternatively, some may impose a charge on redemption instead when investors sell their unit trusts. These charges are paid to the distributors (i.e. the advisers and the banks) who help to sell the funds. And on top of that, distributors may also receive trailer fees yearly from the fund manager for as long as their clients remain vested. If you are wondering where fund managers get the money to pay these trailer fees? Well, it comes from a fund's management fee which is included as part of its yearly running expenses which you are paying.
Exchange Traded Funds (ETFs), on the other hand, are not as commonly utilized by advisers. This is despite the wide variety available today in the market and its size. The total assets managed under ETFs have grown close to USD 10 trillion today. And you can easily buy or sell these ETFs anytime on the exchange they are listed during market hours just as you would trade a stock. Their fees and expenses also tend to be much lower compared to unit trusts. In addition, solutions implemented with ETFs typically do not come with upfront sales charges, and neither do ETF providers dish out trailer fees to advisers. But unlike unit trusts, most ETFs are passive funds that only seek to replicate market indices so they may not sound as “sexy” as unit trusts, most of which are actively managed.
I have summarized the key differences in the table below.
Then the key question is: do actively managed unit trusts outperform passive ETFs? Because if they do, then that would justify the higher fees an investor needs to pay. So, let’s find out for ourselves.
How does an ETF stack up against comparable actively managed unit trusts?
Let’s say I am looking to invest in US large-cap growth stocks and I do not want to go down the route of picking and buying individual stocks myself. So I am contemplating between using ETFs or unit trusts. I picked an ETF - iShares Russell 1000 Growth ETF (Ticker: IWF). Then from Fundsupermart, I found 2 possible unit trusts candidates - the Allspring US Large Cap Growth Fund, and the FTGF Clearbridge US Large Cap Growth Fund. Both these unit trusts, like the ETF, are also officially benchmarked against the Russell 1000 Growth Index. So this is a fair comparison exercise.
Let’s put aside the initial sales charge for now and look at how they stack up against each other since 2008. That is a good 15 years that covers both bear and bull markets so we can take that as a proxy for longer-term performance. All the returns you see are in SGD terms.
The iShares Russell 1000 Growth ETF outperformed both unit trusts from 2008 – 2023 (till 11 May 2023) by a big margin in terms of the total returns delivered. It delivered a 356% return while AllSpring’s unit trust only did 227% and FTGF Clearbridge 256%. On average each year, the ETF outperformed the unit trusts by 1.7% - 2.1%. Incidentally, the annual total expense ratio of the ETF is just 0.18% vs 1.74% for the AllSpring unit trust and 1.72% for the FTGF Clearbridge unit trust. The total expense ratio is what you have to pay for investing in the ETF and unit trusts yearly as part of their running expense. This is regardless of whether you invested in these funds through advisers, banks, or directly through a broker.
So, this ETF clearly smashes its unit trust competitors.
An upfront sales charge drags the unit trusts' performance down even further
As mentioned earlier, if we buy the unit trusts through advisers or banks, we may pay an upfront sales charge. Let’s take the sales charge to be 5%. And if we factor that in, the unit trusts performance can only fall further behind the ETF.
What this means is that $10,000 invested in the ETF would have grown to $45,600 while the same amount invested in the AllSpring and FTGF Clearbridge unit trusts would only give us $31,100 and $33,800 respectively.
Did the managers of the unit trusts deliver any value add at all?
It is quite evident that the sales charge as well as higher fees and expenses of the unit trusts have a significant impact on their performance. But having said that, we still can’t determine if the managers of the unit trusts are adding any value in terms of their stock picking and portfolio management skills. To get a fairer picture, we need to strip out all the sales charges, fees, and expenses. We can do that in an approximate way by adding back the fees and expenses incurred by the ETF as well as the unit trusts each year. This will give us a better sense of how the active managers are doing. Because if they have an edge, they should be able to outperform the ETF over the long term with fees and expenses out of the equation.
Both unit trusts’ performance increased tremendously if fees and expenses are taken out. It should be very obvious that they are a big chunk of where your lost returns went. However, even after excluding them, the unit trusts still fall short of beating the ETF. So, in this instance, I would have to say the managers underperformed. And even if the results here show they outperformed, it is also still not enough to cover the higher costs they charged.
But this is just a simple select study on 3 funds, so the results would not be representative unless we have a large-scale study of how one performs against the other as a group. While I have not done one myself to confirm my thoughts, Morningstar did just that, and let’s see what are their observations.
A larger sample study by Morningstar - Active Funds Vs Passive Funds
In this study, Morningstar compared the net-of-fees-and-expenses performance of nearly 3000 actively managed funds in different categories against a comparable basket of passive investable peers which can include both index mutual funds (unit trusts) and ETFs. Note that index mutual funds are passively managed. They replicate market indices and cost less than their actively managed counterparts. So in terms of investment approach, they are pretty much similar to passive ETFs. This is a study where you purchase the funds directly yourself. There is no mention of sales charge so I believe they are excluded.
Here are a few important observations made in the study.
1. Active manager's success rate in beating their passive counterparts generally dropped as the investment period becomes longer.
A quick look reveals that, for most categories, the success rate of active managers beating their passive peers dropped as time goes by. For example, under the US Large Growth category which is also where my earlier comparison falls under, we can see that active managers never outperformed their passive peers. It has a 37.5% success rate in the past 1 year or in 2022. But if we stretch the period to 15 years, that success rate drops to a pathetic 3%. For those of you who are tilted in favor of value, US Large cap value actively managed funds did fare somewhat better, but even then its success rate over a 15-year period is just 10.9%.
2. There is not a single category of active mutual funds that beat their passive counterparts over a 15-year period or longer.
With shorter periods i.e. those 10 years and below, there are still some categories of actively managed funds that produce outperformance. But when we look at 15 years or more, there is not a single category of actively managed funds that beat their passive peers.
3. Small-cap or mid-cap funds, non-US foreign funds, and non-equity funds seem to do better.
The data also shows that US large-cap actively managed funds fared the worst. Both mid-caps and small-caps active managers did better. Meanwhile, actively managed foreign funds (i.e. non-US centric), did a better job than those focusing only on the US. This indicates the challenge active managers face in delivering an edge on large established segments of a highly competitive US market. This should not be surprising because these are the segments most institutions have a share in and it will be difficult to find inefficiencies to exploit.
4. Low-cost active managers did better than high-cost active managers
The active managers within the same category whose costs ranked in the bottom 20% significantly outperformed their counterparts whose costs are ranked in the top 20% over a 10-year period. Again, this should not come as a surprise. We have seen in the example I gave earlier how cost can drag performance down by a big chunk over the long term. So managers whose funds have higher costs and expenses will have to outperform by a non-trivial margin before they can beat their competitors.
What Should You Do If You Want To Build A Portfolio?
I think the numbers we saw clearly indicate that the fees and costs are an important determinant of a fund's long-term performance. Yes, for sure, there will be active managers that outperform even among those that charge top fees. But statistically, most don’t and you are better off with a low-cost passive fund such as a comparable ETF or a index mutual fund. So, if you are looking to build a portfolio whether by yourself or going through an adviser, opt to choose such options over pricey actively managed unit trusts. Or if you have to use actively managed unit trusts, then target those that charge lower fees. But if for some reason you have to go for high-cost actively managed unit trust, then at least run an analysis (it can be as simple as the one I did earlier) to see if the manager does indeed have an edge. Having said that, I am coming from a pure cost and performance perspective. Ultimately, it is your call.
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